Investing in Penny Stocks Is Still One of the Dumbest Moves on Wall Street

When compared to more traditional equities, penny stocks are less expensive dollar wise. But they're also highly volatile and the companies behind them are often cloaked in obscurity.

"Penny stocks truly are the Wild West of the financial landscape," says Robert Johnson, President and CEO of the American College of Financial Services.

Johnson is in good company with that assessment. "The fraudsters flock to the new and attractive space. I guess that shouldn't surprise me, but it does. And the amount of fraud that exists and has existed in the penny stock space," said Securities and Exchange Commission Chairman Jay Clayton at an event in Chicago this week on the topic of fraud in initial coin offerings and penny stocks. "Both of these issues trouble me."

Nearly half of all ICOs failed last year, many of them at the hands of fraud. Sounds like the boiler-room days of the late 1990s, where pitching fraudulent penny stocks was the norm. It still looks like it's the norm.

A simple Google search of "penny stock fraud" narrowed down to the last year yields scores of reports of criminal activity, indictments, lost fortunes and jail time related to penny stocks.

From 2008 to 2013, California banker Zirk de Maison reportedly created nearly a half-dozen small public shell companies. He then offered public shares in the companies in penny stocks, netting himself $39 million over a handful of years. After pleading guilty to fraud in 2015, de Maison was sentenced to more than 12 years in prison and ordered to pay $39.1 million in restitution.

Last fall, the SEC filed fraud charges against cannabis company CannaVest and its CEO, Michael Mona, Jr., after the company allegedly inflated its share price to reach a market capitalization of $26 million. Mona's business partners at CannaVest had been lauded before the federal crackdown as the first "pot stock billionaires."

Those are just some of the many cases brought by federal authorities against alleged penny stock pushers and market manipulators of late. Among the most famous cases of all-time is that of Jordan Belfort, the "Wolf of Wall Street." His Stratton Oakmont brokerage became a "penny stock boiler room" in the late 1980s and early 1990s, operating a number of pump-and-dump schemes before Belfort and his cohorts were taken down by the Feds.

While Clayton didn't go as far as to promise further regulation in the penny stock space, he did admit that he has his work cut out for him in year two of his tenure on the topic. "I believe we must continue to explore whether our regulatory approaches appropriately protect retail investors," Clayton said.

"The regulators have to practice triage and put their limited resources to their highest and best use," Johnson explains. "That isn't protecting against smaller scale frauds in penny stocks, but is in larger cap securities that are held by more investors."

The SEC writes on its website, "Because of the speculative nature of penny stocks, Congress prohibited broker-dealers from effecting transactions in penny stocks unless they comply with the requirements of Section 15(h) of the Securities Exchange Act of 1934 ("Exchange Act") and the rules thereunder."

Those rules provide that a broker-dealer must approve the customer for the specific penny stock transaction and receive from the customer a written agreement to the transaction, furnish the customer a disclosure document describing the risks of investing in penny stocks, disclose to the customer the current market price for the penny stock and disclose to the customer the amount of compensation the firm and its broker will receive for the trade.

Judging by Clayton's comments, penny stock problems have continued to fly under the radar of regulators -- and existing regulations. Because they're not as high-profile as blue-chip Dow members like General Electric (GE) , for example, they still get less oversight.

What's more, it's not just the risk of fraud that makes penny stocks a dumb idea. It's also their actual capacity to make investors money.

Stocks on the major exchanges have a narrow bid-ask spread most of the time, Johnson explains. The price a seller can realistically snag and the price a buyer is willing to fork over are typically close. But for penny stocks, the same can't be said.

"With penny stocks ... the bid-ask spread can be substantial," Johnson said. "This makes it very difficult for investors to realize a gain."

Penny stocks continue to try to take advantage of the human sentiment that if something doesn't cost much, it's cheap. They might not carry a big price tag, but that doesn't mean they've teed up enormous gains. Don't get caught up in the hype, or you may become the dumbest on Wall Street.

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